Find the next Seek or REA Group

By Richard Hemming, Under the Radar ReportApril 2015min read

How to spot the next big money makers that disrupt their industry.

When online jobs advertiser Seek listed in April 2005 it had a market value of about $560 million. At that time, Fairfax Media, publisher of numerous newspapers, including the Sydney Morning Herald and The Age, had a market value of about $4.1 billion.

Fast forward to today and the situations are not quite reversed, but are reversing. Seek's market capitalisation is close to $6 billion, while Fairfax's is just shy of $2.3 billion.

Back in fiscal 2005, Seek was generating revenues of $70 million and a net profit of $19 million. This financial year analysts forecast Seek will achieve record sales of $866 million and net profit of $290 million. Fairfax's revenues have not moved much over the period, being $1.87 billion back in 2005 and should be about $1.81 billion this financial year. But it made $241 million in net profit at the start of the decade and is now forecast to make $110 million this financial year.

The companies' contrasting fortunes show how Seek's "disruptive" business model of providing companies a cheaper and more effective means of advertising for employment, usurped Fairfax's older redundant model, which was based on its now non-existent Classifieds section, referred to most notably by the late media mogul Kerry Packer, as "rivers of gold".

What is a disruptive business?

A disruptive business takes existing demand (in this case for jobs advertising) and introduces a new business model that undercuts the established competitors, effectively taking their profits away from them.

In its efforts, Seek has been ably assisted by fellow online advertiser, realestate.com.au owner REA, which also has a lower-cost business model. Neither has had to fund lots of journalists and newspaper printing and distribution plant and equipment, as Fairfax has.

Arguably, you could classify innovators in the disruptor category. These are companies that create a new market that has never existed. You could include the world's most successful companies, Apple and Microsoft. These companies create new reasons for spending money, although for the innovators, the sales cycle is often much longer because they need to convince people that what they're doing is worth paying for.

Either way, the super profits that disruptive business models can make are enough to satisfy any investor hungry for returns. If you were lucky enough to get stock in the Seek float, you would be making more than eight times your initial investment, based on the current price.

Disruptive technologies abound. You just have to notice that the local video store has largely disappeared. In its place are on-demand movie and TV streaming services, such as Netflix, which now has about 57 million subscribers worldwide. Watching the battle between rival streaming services in Australia - which also include Stan, Presto, Foxtel Play, Quickflix and Ezyflix - will be fascinating.

Finding the next Seek

For investors, a big question is how or where to find the next Seek.com or REA, whose success has now transformed them from being disruptors and placing them firmly into the new "Establishment".

This is the fertile ground for investigation. After all, back in 2005 Seek was a small-cap stock because its market capitalisation was well outside the S&P/ASX 200 index. It was at the larger end of what we define as small caps, which in the main are stocks with a market capitalisation below $300 million.

(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article.)

Consequences in being disruptive

The first thing to note is that being disruptive has its consequences. By definition, you are stepping on the toes of gorillas. We are seeing the punishment meted out by conventional oil producer Saudi Arabia on the new kids on the block, the unconventional oil and gas producers, or more commonly known as the "frackers" and largely based in North America.

Following the textbook of Competitive Behaviour 101, OPEC, which is led by Saudi Arabia, is pumping out more oil in order to depress the price and force the newer operators - which in many cases have limited monetary reserves - out of business. It seems to be working, because many of the fracking companies are funded by debt.

The cloud

Where the success of disruptive technology has been mixed is in the internet cloud, which refers to the convergence of software and hardware in computer technology. Until recently you bought software and downloaded it onto a computer. After five years or less you would have to replace it. In economic terms, software was capital expenditure, rather than operating expenditure, for business.

Now you can buy the software from someone else, the cloud provider, who does all the work for you. Instead of getting someone to set it up, you set it up over the internet.

Companies such as Macquarie Telecom, ASG and Empired have had varying degrees of success converting their customer based to the internet cloud, which means lower profit margins but more consistent revenue streams.

Late entrant in an established industry

On a more conventional front, ERM Power has had success entering the electricity retailing business and taking market share from much bigger operators such as Origin, AGL and TRUenergy in the corporate space.

Being a late entrant means that ERM's systems are state of the art and it does not have the legacy issues of its bigger, more cumbersome competitors.

Utilising new technology

Then there are companies that are embracing new technologies and have achieved initial success. For example, Ingenia has transformed itself from an unwieldy property trust into a focused operator and developer of aged-care communities utilising manufactured housing. This should produce average annual earnings growth in the region of 30 per cent or more over the next few years.

Elsewhere, MyNetFone is the quiet achiever of the telco space, having utilised next-generation voice over the internet protocol (VoIP) technology to build an Australia-wide infrastructure that sits alongside the likes of TPG, Telstra, Optus and iiNet.

A new way of accessing IPOs

There are many other small caps we could name that have disruptive business models.

It is worth noting that disruptive influences are benefiting the investment community in ways other than super profits for those who spot a trend early.

The emergence of discounted broking services has given individual investors unprecedented access to ASX-listed companies. This has been coupled with the rise and rise of the self-managed superannuation fund (SMSF) sector in Australia, which has made investors more self-reliant than ever.

Following this trend is the ASX BookBuild facility, which was developed by Ben Bucknell, chief executive of On-Market BookBuilds. He says: "Until recently many Australian investors were unable to participate in initial public offerings (IPOs) or other capital raisings. With the advent of ASX BookBuild, this has changed."

This article appeared in the April 2015 ASX Investor Update
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This article appeared in the April 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with MyASX.

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